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I root for Brazil in futebol/soccer in all cases except one: when they play the United States. So I was a US fan as I sat down last night to watch yesterday’s Confederations Cup finals with my mother-in-law, who is from Rio and was, of course, rooting for Brazil.

Clint Dempsey’s one-touch goal 10 minutes in had me believing the US could stay competitive — Landon Donovan’s beauty at 26 minutes had me believing they could win (it also had me jumping off the sofa, yelling and pointing at my shirt “for the crowd”).

Tony Howard, our goalie, was playing loose and fast, Brazil looked “off” and Dunga looked like he was pondering his next career move.

There was only one negative indicator — my mother-in-law was moving around the kitchen with a slight SMILE on her face, doing the dishes, glancing at the TV, apparently untroubled that Brazil was down 2-0.

Like any Brazilian, she knows soccer and she especially knows Brazilian soccer. It’s strange, actually, in that she does not know or care about sports but she cares and knows about Brazilian soccer. She knows how it is supposed to look, what the players are supposed to be doing, how their game is supposed to be played. She has 67 years of history with it.

Thus her comfort level, down 2-0, made me uneasy. The only words she uttered: “It’s early.”

What came next was something she fully expected. Toward the end of the first half and throughout the second half, the US faced a Brazilian onslaught. Wave after wave of attack, the ball moving from one side of the field to the other, Kaka setting things up, Fabiano finishing them. The US looked more and more tired — they were just trying to hold on, to run out the clock.

No such luck, Brazil scored one minute into the second half, then again 18 minutes in, then finished it off with six minutes left. By the end, the world was reminded of the greatness of Brazilian soccer, of its “Beautiful Game”.

The only time during the whole game that my mother-in-law got upset was when Brazil appeared to have scored but the referees denied it. It was an insult and an injustice to her. In fact, her last words of the night to me where, “It was actually FOUR to two.” (Margin of victory, especially over an inferior opponent, counts in Brazil.)

Some random thoughts:

It’s hard for Americans to understand the depth of soccer in Brazil life. It is everywhere. Go to the Rio beaches and see the bloodsport pickup soccer games, the intense “foot-volleyball” games, the kids soccer camps.

If that doesn’t do it for you, try to imagine if everyone in the US played ONE SPORT. Not football, basketball, baseball, hockey, golf, etc. but 300 million people focused on one sport. Then you begin to get the idea. The only difference is that Brazil is 200 million people focused on one sport. (Yes there are other sports in Brazil but they have the same relation to soccer as professional bowling does to the NFL.)

It’s for this reason that I don’t believe the US will ever challenge Brazil’s (or Italy’s, Germany’s, etc.) dominance in soccer — there is too much dilution of our athletic talent by other sports.

Anyway, in the end, the better team won and, in many ways, it was awesome to watch. That brings up my last random point: when people ask me what it was like to play pro football (US football), which I did very briefly in the early ’90s, I always mention the speed of the game. Sitting at home watching TV, or even watching from the stands, you have a wide angle view. This makes things appear to develop much more slowly than the reality on the field. At field level, things are happening at light speed. Players are FLYING. For me, it was awesome to see the deftness and accuracy of the Brazilian attack, knowing the speed at which they were doing it. And the final testament to Brazilian players’ skill? They make it look easy.

There is a saying in Hollywood that “A good script gets found.” The same is true in sports — if you are a good enough basketball player, the NBA will find you, whether you are playing on a Division III team in Alaska or for Duke University. I think that generally the same is true in venture capital — if you are a good startup and you make an effort, you will get an audience with at least a few decent VCs.

Therefore, paying a consultant to find you investors is usually, not always, a waste of money. Brad Feld in his blog Ask the VC had a good post about this in December 2007. I recommend reading the comments to it as well.

Personally, I feel that outsourcing fundraising to people can be of great help to a startup BUT only when those hired have relevant experience and can truly help the company. I don’t agree with Brad that it is important that the founder do it themselves. I do believe, however, that the percentage of brokers/consultants that work in this area and REALLY add value is less than 10%.

Here is the major problem: almost all consultants/brokers are motivated to tell a startup that they can raise them money, regardless of whether the startup actually has a chance of successfully doing so. In other words, where the brokers/consultants really rip off the startup is in taking them on as a client when the company does not have a realistic chance of raising capital. Any fool can throw together an executive summary and email it to VCs. It takes an experienced, ethical player to make an objective appraisal and give an honest “go/no-go” to the startup before time and money is wasted. Many times the best advice to a startup is to focus on building the business and hitting milestones before looking for capital. If it is not possible to hit those milestones before raising venture capital, then the startup needs re-evaluate its business plan.

The best rule of thumb is to look at the background of someone offering these services and see if they have previously raised money for early-stage companies (perhaps for their own startup). It is not good enough just to have been in the financial services industry in general: in order to make an objective appraisal of the situation, they need experience in the early/growth stage world. Obviously, direct experience in the same vertical (e.g., consumer internet) also helps a lot, for obvious reasons, including that the broker/consultant presumably has relationships with investors in that space.

A final distinction – paying a success fee is one thing, paying a retainer is another. If someone finds you money, it is usually reasonable that they expect a finders fee or commission of some sort. Paying a retainer to a broker/consultant, however, drains critical funds from the startup and should be done only in the 10% of the cases where the broker will bring real value.

In the last post, we explored the case AGAINST angel investing. Today let’s look at the case FOR angel investing, which really comes down to one word: diversification.

Modern Portfolio Theory asserts that an investor can reduce the risk and boost the long-term return of his investment portfolio by investing across different asset classes. Simply put, if one asset class goes down, another may go up or at least hold steady.

A sample portfolio may have US Large Cap stocks, US Small Cap, International (heavy on Brazil and China!), Corporate Bonds, Treasury Bonds and Gold. The actual assets and proportion of each depends on the profile of the investor — income, age, net worth, financial goals, etc.. It can get complicated, which is why people pay financial advisors for help.

Institutions — pension funds, endowments, insurance companies etc. — have advantages over individual investors in putting together portfolios because they have access to assets classes that individual investors don’t (unless the individual is extremely wealthy). Specifically, institutions have access to alternative assets: hedge funds, private equity and venture capital. Adding alternative assets has allowed some portfolio managers, such as David Swensen at Yale, to achieve outsized returns over a long period of time.

Assuming you are not an extremely wealthy individual, however, you cannot get into alternative asset funds. Yes, you could buy shares of publicly-traded hedge funds (Fortress), private equity firms (BlackRock, GP Investmentos) or Venture Capital firms (Harris and Harris, Ideaisnet) but the track record of publicly-traded funds is mixed at best — more on that in another post.

All this is a long winded way of getting to the point — angel investing is a way for an individual investor to add alternative assets to their portfolio.

If one is going to angel invest, however, I recommend doing it as 1) an active investor and.or 2) part of an angel group. By active investor, I mean essentially becoming part of the company, at least part time, until the company is through a Series A round or some equivalent point of stability. As such, you can help the company make strategic decisions, access your network, perform business development and generally exercise control in a way that increases the chances for success of your investment.

The other way is to join a group of angels. I like this method — groups like New York Angels or Gavea Angels (Rio) bring the resources of its many angels to bear in evaluating investments (diligence) and helping portfolio companies. In joining these groups, you are essentially re-creating the benefits of a venture fund — professional management, industry expertise, ongoing oversight, etc.

The Kaufmann Foundation came out with a study in 2007 asserting that angel investors participating in organized angel groups achieved an average 27 percent internal rate of return! That’s amazing and I am not sure I believe it. I have also heard the theory that, if one puts together a portfolio of over 25-30 angel investments, he will tend to see astronomical returns. Again, I am not sure I buy it but, if the investor is active and/or part of good angel groups, perhaps this is true.

I guess the last part of the case FOR angel investing is qualitative — it’s fun. I really enjoy interacting with entrepreneurs and startups and that, beyond any type of financial reward, provides its own return on investment.

…at least, that was the original theme of this post.

Lately, however, I have seen how angel investing might make more sense than I originally thought. Let’s look at both sides (I have been angel/seed investing for almost ten years and don’t feel strongly about proving one side of the argument or another.)

First, the case AGAINST angel investing. It can be summed up fairly simply — dilution. Because the angel does not have enough money to keep his pro rata ownership in subsequent rounds and, even if he did, the VCs may not let him participate, he is likely to be diluted down to a small percentage of the company by the time there is a liquidity event.

In addition, his shares will likely be in common stock, while subsequent VCs will have preferred shares; this means, among other things, that the VCs will have a “liquidation preference” that ensures that they will get their money out first. Finally, the angel will not have a board seat or any other form of control over the company.

Let’s analyze three scenarios for an angel investment: a home run investment, a return of investors’ money investment and a loss. VCs generally expect their portfolio companies to fall into each of these categories in equal proportion.

I. The Home Run Scenario,

Angel Investment $100,000
Pre-money Valuation $400,000
Post-money Valuation $500,000
Post-money Angel Ownership 20%

Year Two
Pre-money Valuation $3,000,000
Series A Investment $2,000,000
Post-money Valuation $5,000,000
Post-money Angel Ownership 12%

Year Four
Pre-money Valuation $10,000,000
Series B Investment $4,000,000
Post-money Valuation $14,000,000
Post-money Angel Ownership 9%

Year Five
Exit $50,000,000

Gross Return to Angel 43x
Angel IRR 112%

In the Home Run scenario, everyone is happy — the VCs come in at the Series A and Series B at ever higher valuations and, in year 5, there is a exit that at a value that obviates the liquidation preferences of the VCs. In other words, it doesn’t help the VCs’ return to exercise the liquidation preference so everyone shares in the proceeds of the exit proportionately. There is a back-slapping closing dinner at Fogo de Chao on Park Avenue.

2. The VCs Barely Get Their Money Back

Angel Investment $100,000
Pre-money Valuation $400,000
Post-money Valuation $500,000
Angel Ownership 20%

Year Two
Pre-money Valuation $3,000,000
Series A Investment $2,000,000
Post-money Valuation $5,000,000
Angel Ownership 12%

Year Four
Pre-money Valuation $10,000,000
Series B Investment $4,000,000
Post-money Valuation $14,000,000
Angel Ownership 9%

Year Five
Exit $8,000,000

VC Liquidation Preference $6,000,000

Remaining for all Investors $2,000,000

Gross Return to Angels $171,429
Gross Return Multiple 1.7x
Angel IRR 11%

Now, we have some problems. In this scenario, the portfolio company stumbles and exits at an $8,000,000 valuation. In theory, this should be okay for the angels, more than okay, since they own 9% at exit. The problem is that they own common shares and the VCs own preferred shares, which have a liquidation preference. As I mentioned, the liquidation preference means the VCs get their money out first, so instead of all investors splitting up a pie worth $8,000,000, the VCs take out their $6mm of invested capital, leaving $2,000,000 for all investors (including the VCs) to split pro rata. The result is an 11% IRR for the angels, which is meager considering the massive risk profile of the investment.

By the way, this scenario assumes a 1x liquidation preference; a 2x liquidation preference, not uncommon, would mean that the VCs get twice the amount their invested capital back before the common stockholders get a share of the proceeds. A 2x liquidation preference in this example would result in a complete loss to common shareholders.

3. Complete Loss

We don’t need a model to show what happens to the roughly 1/3 of VC investments that go under. Suffice it to say, in this example, if the exit results in less than $8mm in proceeds, the return to angels quickly drops to $0.

So we see how high the odds are stacked against angels. David Rose of the New York Angels has said that he needs to believe an angel investment will return 20x before he will invest. You can see why: angels are entering at the riskiest point of the company’s life and, generally, face years of dilution before seeing their portfolio company exit. An angel investment needs to be a huge home run to provide an ample risk-adjusted return.

It’s worth noting two other variables that control how an angel investment will perform. One of the largest determinants is valuation at the point of angel investment. I listed a pre-money of $400,000 in the above examples. This is possible if you are dealing with a first-time entrepreneur at the very inception of the company. If you are dealing with a proven entrepreneur (i.e., the kind you want to actually invest in), the valuation is likely to be much, much higher. Two of the seed rounds I took part part in with successful, “repeat” entrepreneurs, both had $10mm pre-money valuations. So if an angel invested $100,000 they started out owning less than 1% of the company. With numbers like that, the possibility of a worthwhile return for the angel becomes infinitely smaller.

Another major factor involves the capital requirements of the business. In the two examples above, the company takes in only $6mm total in the Series A and B rounds. If you are investing in a web-based software company or a consumer-facing internet play, this is possible. If you are investing in a device-based business, however, forget it. A company that needs to build a product: a medical device, a music player or a even just a metal widget, will require a lot more capital, which means more dilution for the angel (unless the valuations go up astronomically at each round). So, IMHO, angels should stay away from “product” businesses completely. Pharma and the massive amount capital required there is not even worth mentioning in the same breath as angel investing.

We’ll review the case FOR angel investing in the next post.